by Jason Mitchell

The contrast between Argentina and Brazil could not be starker. The latter goes from strength to strength and is the darling of the international buyside after securing investment grade from two major agencies. Its formerly superior southern neighbor continues to dig itself into a hole, setting the stage for a repeat of the 2001 crisis.

“Investors have started to get tired of Argentina, there is such little positive news coming out of the country,” says Alejandro Cuadrado, LatAm economist at Merrill Lynch. “If the farmers’ strike drags on, investors will continue to punish Argentine bonds.” As of early June, it was unclear how long the agricultural dispute would last.

Based on fundamentals, including a solid soft commodities base and ample human capital, Argentina should have a much firmer yield curve, particularly at the short to medium-end. But the five-year CDS is at around 600 basis points over swaps, implying a 30%-40% probability of default, Cuadrado adds.

In January 2007, Argentina’s component of JPMorgan’s EMBI+ slipped below Brazil’s, bottoming at 185 basis points against Brazil’s 190. But since February 2007, when the Argentine government started to manipulate inflation data, the curve has been pounded. As of early June, Argentina was at 535 basis points versus 191 basis points for EMBI+ Brazil. In April, S&P revised its outlook on Argentina’s B+ rating to negative, following the resignation of the economy minister.

“The yield curve was trashed during the last year and although we have seen a reasonable recovery in the short-end this year, the mid and long-ends remain at high yields,” says Marcos Esteves, head of global markets for Deutsche Bank in Argentina.

Despite the pick up in yields, investors are repulsed by political risk. “Currently, we will not invest in Argentina,” says Simon Lue-Fong, head of Pictet Asset Management’s $100 million LatAm local currency debt fund. “Government policy is what really puts us off. It has the wrong policy mix and now the government does not have many tools left to sort out the country’s problems.”

Argentina has a fiscal surplus of 1.1% of GDP and an annual trade surplus of $12 billion. Its central bank has a $48.8 billion cushion of dollar reserves. After stopping debt payments and enforcing a harsh haircut on creditors, the economy has grown at an average rate of 8.8% during the past five years, according to the IMF. Local economists estimate an annualized inflation rate of 25%.

Technical Default?

Some commentators say manipulation of the inflation data through government statistics agency INDEC amounts to a sovereign default, since the administration has saved interest on its CDR-adjusted (index-linked) bonds to the tune of an estimated $1.6 billion between February last year and May 31 this year.

“It took some time for the implications of the INDEC interference to sink in,” says a leading bond trader at an international shop. “Many hedge funds were long on subprime exposure, so they decided to hedge by going short on Argentina. They were expecting Argentine assets to go even more negative, which has in fact been the case.”

Investors feel let down by the Cristina Fernández de Kirchner administration. Initial hopes of a more market-friendly approach than the government of her predecessor and spouse quickly faded. This has had a knock on effect on funding, which the government is looking increasingly to Venezuela to provide.

In April, Argentina issued a Bonar 13 with a nominal value of 867.2 million pesos and a yield of 13.3%, the most expensive since the country re-entered the financial markets after restructuring in mid-2005. This was the first bond issued under Cristina´s presidency, which began in December 2007. An unsettled macro environment should keep rates high and government officials looking to Caracas for cash.

“The government will not like it but I think growth could drop to around 4%,” says leading local economist Miguel Kiguel. “This would help to stabilize inflation at around the 20% to 25% level, removing the risk of it accelerating.”

Kiguel says the economy’s current capacity growth rate is around 4%-5%, at the present investment level of 24%. There are risks to his forecast: Kiguel believes the government must rein in its growth in spending to a maximum annualized rate of 30%, from the June level of 41%.

The country is also vulnerable to an exogenous shock if Chinese demand for soft commodities drops or if there is a significant fall in the price of soya beans, which would mess up the government’s fiscal calculations. The price of soya has also been pushed up by speculation in the futures market, and is susceptible to a correction in that market.

Recently, Argentines have been withdrawing pesos and converting to dollars. The Central Bank has attempted to stem depreciation by selling US currency – it has sacrificed $1.7 billion in reserves between March 27 and May 31.

Meanwhile, a major problem for exporters is the fact that high inflation erodes competitiveness in real terms and prompts the real exchange rate to converge to its long-term equilibrium. A further bout of inflation could bring such a convergence about more swiftly, prompting a hard landing for the economy.

The government is not yet contemplating a change in economic strategy. It believes it can bring down inflation by a social pact, or incomes policy, between employers and workers. Argentina already has high rates, with the benchmark Badlar at 17% in early June.

Killing the Markets

Political instability has been good for secondary trade, but it puts a dampener on corporate financing. Daily volume in fixed income instruments was $1 billion in early June, from $800m a year ago, according to the country’s principal fixed income exchange, the Mercado Abierto Electrónico or MAE. Equity trading on the Merval pales in significance, at just $10 million a day.

However the local private sector, which includes several world class companies, is starved for funds. “Lots of corporates are seeking longer-term financing but as long as the government’s yield curve remains at current levels, I doubt there will be much room for substantial expansion,” says Esteves.

Argentine corporates are seeing significant restrictions in terms of size and tenor. Engineering and technology group, Industrias Metalúrgicas Pescarmona (IMPSA), issued the biggest bond so far this year for $65 million late May. It paid 9.5% nominal for a one-year tenor. Private banking group, Nuevo Banco Industrial de Azul, did the second largest issue, a 73.39 million pesos one-year mid-February at Badlar plus 2.5%.

Credit card provider, Compañía Financiera Argentina, did the third biggest issue for 26.7 million pesos on May 9; its interest rate is Badlar plus 6.5% and it has a two-year tenor.

Local capital provided to companies fell to $1.81 billion for the first five months of 2008, a drop of 44.4% versus the corresponding period of last year, according to the Argentine Institute of Capital Markets. Corporate bond issuance dropped by 92.6% while new share issuance dropped 21.0%. However, the supply of issuance of financial fideicomisos by large corporates and SMEs rose 37.8% and 11.2%, respectively. According to Moody’s, the total value of the issuance of fideicomisos, the main type of ABS in the country, added up to 3.8 billion pesos in the year to May 31.

The subprime crisis and rising inflation have also taken their toll on ABS. Total securitizations in Argentina last year amounted to 8.4 billion pesos and ABS represented 83% of the total, according to S&P. In 2006, total securitizations added up to 7.5 billion pesos and ABS made up 80%. At the end of April, primary issuance was down almost 35% year on year, according to Merrill Lynch.

“In terms of the structured product markets, we’ve seen a sharp deceleration in primary issuance, as the local market struggles to cope with notably higher launch spreads that are still above historical [pre-subprime crisis] levels,” says Magda Guillen, LatAm structured product analyst at Merrill Lynch.

“Demand for MBS would likely be high, but current spreads on longer-term transactions mean mortgage-backed issuance remains unaffordable for most issuers at today’s rates. This is largely due to lingering uncertainty about Argentina’s long-term macroeconomic stability, particularly with respect to long-term inflation prospects,” adds Guillen.

The government has a window of a few months to rein in spending and put the lid on the inflationary boiling-pot, probably through even higher interest rates. Otherwise, Argentina faces a hard landing, as inflation eats away at consumer confidence and reduces the real competitiveness of the country’s exporters.
Meanwhile, external funding needs stack up and there is a heavy maturity schedule looming in 2009, but the sovereign lacks access to many investors. Argentina’s bond markets look set to continue receiving a pounding for the next few months and the hit could get even worse if the economic outlook darkens. LF